What happens to money market cash on the sidelines?

A reader asks:

I have a theory of the stock market. The large amount of cash in money markets, HYSAs etc. means that a “down” day(s) for the stock market will be quickly reversed by buying the dip. And this will continue until cash balances drop significantly. Thoughts?

Exist much of cash sitting in money market funds right now:

That is 6.3 trillion dollars, which is almost double the amount that was in these funds before the pandemic.

It makes sense. The Fed raised short-term interest rates. You can get more than 5% on these funds. Long-term bonds have much higher interest rate risk and have been crushed when rates have risen. These are short-term debt instruments that do not decline in value on a nominal basis.

Money market funds have been a boon for investors who needed a mix of yield, protection against volatility and liquidity in recent years.

But what happens when the Fed starts cutting rates?

Returns on money market funds will fall. The Fed is likely to cut rates quite quickly. Those 5% returns could turn into 2-3% returns in a relatively short period of time if inflation continues to fall, the economy slows further, or some combination of the two.

It’s a fair question to ask whether this cash on the sidelines will provide a buffer against falling stock prices.

Let’s start with a quantitative analysis before going into the more qualitative aspects of this theory.

The Federal Reserve has quarterly data on money market assets going back to the mid-1970s. I looked at the change in quarterly money market assets and the corresponding quarterly S&P 500 return.

It was hard to find a strong relationship one way or the other:

To test this theory, I looked at bottom quarter returns for the stock market to see if it affected money market flows. You were twice as likely to see asset flow in money markets in a lower quarter than out of money markets.

So it’s not as if investors have used money market funds as a form of cash on the side in the past.

But what about the returns?

We are heading into a rate cut cycle. Are Money Market Funds Cashing Out as Yields Fall?

Not necessarily. Here’s a look at money market fund assets versus returns:

Averages with decreasing rates are highlighted on the chart. Between 2005 and 2009, yields fell, but money market assets rose. The same thing happened during the pandemic.¹

So while it would be safe to assume that investors would struggle a bit to put money to work during a bear market, the opposite is more likely. People get scared when stocks go down and put more money into cash.

Will this happen the next time stocks drop?

We will see.

It’s also worth pointing out that money market funds only date back to the mid-1970s. Here’s a quick history lesson I wrote about these funds in a previous piece:

Vanguard is synonymous with index funds, but it was money market funds that carried Jack Bogle’s company in the 1980s because interest rates were so high.

Banks were limited to the interest they could pay. Then came the first money market fund that allowed people to put their money to work with a bank through existing interest rates.

By 1981, Vanguard owned only 5.8% of the mutual fund industry’s assets. This number dropped to 5.2% by 1985 and 4.1% by 1987. Their most popular series of funds, the Wellington Funds, had 83 consecutive months of outflows.

In the 1980s, mutual fund assets grew from $241 billion to $1.5 trillion. The charge was led by money market funds, which rose from $2 billion to $570 billion, accounting for nearly half of the increase.

So it’s hard to pinpoint how much the stock market affected flows because they were a new category of funds in the 1970s and 1980s.

The other part of the equation is how much of the growth in money market funds has come from bonds or other fixed income sources?

Bonds just experienced the worst bear market in history:

Certainly some of the trillions of dollars that have flowed into the money markets have come from bonds.

When money market yields fall, there’s probably a stronger case for that money to go into bonds than into stocks because cash can act as a form of fixed income.

Additionally, there is a baby boomer retirement aspect of the allocation question. Millions of baby boomers are already retired. During this decade, millions more will retire. Most retirees risk some of their portfolios in retirement because they don’t want/need that much volatility.

What if some of these assets are sticky?

It’s certainly a possibility.

So while some of that cash on the sidelines might end up in the stock market, I wouldn’t bet on money market flows bailing out the stock market when it goes down.

We covered this question in the latest edition of Ask the Compound:



Our resident real estate expert, Taylor Hollis, joined me on the show this week to discuss questions about CD rates, how trusts work, how to protect your finances from a family illness, and how to pay off student loans with a 401k loan.

Further reading:
How Individual Retirement Accounts Changed the Stock Market Forever

¹Assets fell and then stagnated coming out of the Great Financial Crisis, but that was a period with years of 0% returns. I’m actually surprised assets didn’t fall more in the 2010s.